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Even the Top U.S. Oil Fund Is Becoming Bearish About Oil

United States Oil is selling its current contracts. That's a huge warning sign.

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The United States Oil (NYSEMKT:USO)exchange-traded fund (ETF) has been making big news lately. As the largest exchange-traded fund with direct exposure to the price of U.S. oil, shares have fallen nearly 83% so far this year. When benchmark WTI crude oil prices turned negative on April 20, the fund found itself in an uncomfortable position.

Over the last two weeks, the fund has made some extraordinary changes to its portfolio, including dumping all its current oil futures contracts in favor of longer-term investments. And even though USO is just one investment instrument in a big industry that includes heavyweight stocks like ConocoPhillips (NYSE:COP) and Chevron (NYSE:CVX), this is still a big deal for investors. Here's why, and what you should do about it.

Image source: Getty Images.

The price of oil

Basically, the United States Oil fund is designed to offer a way to invest in U.S. oil without having to purchase futures contracts on a mercantile exchange yourself, or buy stock in a specific oil company like Conoco or Chevron.

The fund's entire goal, according to its prospectus, is "to reflect the daily changes in percentage terms of the spot price of light, sweet crude oil delivered to Cushing, Oklahoma, [aka WTI Crude] as measured by the daily changes in the price of a specified short-term futures contract on light, sweet crude oil called the 'Benchmark Oil Futures Contract.'"

In other words, the USO fund is supposed to track the current price of WTI crude (which is dictated by the nearest-term futures contract). But that's not what's happening now.

How it used to work

Prior to April 17, USO's purchasing guidelines were straightforward: The fund invested in "crude oil futures contracts ... in the near month contract to expire (or "front month"), except when the near month contract is within two weeks of expiration, in which case it invests in the futures contract that is the next month contract to expire (the "second month")."

In other words, at the beginning of March, USO bought futures contracts for April delivery (the shortest-term contracts available). It didn't buy any other contracts until the April contracts were within two weeks of expiration, and even then it only bought May contracts. Not two or three months out -- USO was focused on the current crude price.

But on April 17, that changed. The fund's manager, USMC Investments, filed a notice with the Securities and Exchange Commission (SEC) that due to "market conditions and regulatory requirements," it would invest 80% of its portfolio as normal, but would allocate 20% of its portfolio to "second month" contracts. In other words, it was starting to invest in contracts that were further into the future than normal, a sign that oil prices might fall in the short term.

Fall they did. On April 20, the May contracts fell to negative $37.63 per barrel as low demand caused an oversupply that outstripped the nation's oil storage infrastructure. Luckily for the USO, it was already investing in June and July contracts by that point, but over the next week, the fund made four more changes to its portfolio:

WTI Crude Futures Contract Month

Estimated % of USO portfolio, as of 4/17/2020

As of 4/21/2020

As of 4/22/2020

As of 4/24/2020

As of 4/27/2020

June 2020

80%

40%

20%

20%

--

July 2020

20%

55%

50%

40%

30%

August 2020

--

5%

20%

20%

15%

September 2020

--

--

10%

20%

15%

October 2020

--

--

--

--

15%

December 2020

--

--

--

--

15%

June 2021

--

--

--

--

10%

Data source: United States Oil Fund LP 8-K filings.

As you can see, on April 27, the USO announced it was exiting its positions in the current June contracts entirely. That caused the price of those contracts to drop 26.7%. It also announced an intention to invest in contracts as far out as June 2021. Fully 40% of the fund's portfolio is now going to be for contracts more than three months out.

Why it happened

In less than two weeks, the largest U.S. oil ETF -- which has the stated objective of tracking current oil prices -- went from 100% investment in June 2020 WTI futures contracts to 0%.

Some of these changes -- but not all -- were made to comply with regulatory requirements and maximum limits on the number of contracts a fund can hold. That's right: WTI crude prices are now so low that if the fund had invested the bulk of its portfolio in the June contract, it would have exceeded the Exchange's limit on the number of contracts it could own. But the fund's managers didn't just put money into the nearest-term contracts they could access; they're buying contracts up to a year out, indicating they aren't expecting a swift resolution.

They also had this to say in their April 27 8-K filing: "While it is USO's expectation that at some point in the future it will be able to return to primarily investing in the Benchmark Futures Contract or other similar futures contracts of the same tenor based on light, sweet crude oil, there can be no guarantee of when, if ever, that will occur."

Yikes.

What it means for oil investors

When the United States Oil fund isn't actually investing in the current price of United States oil, it's a huge red flag that U.S. oil prices aren't likely to recover anytime soon. That makes sense: There's a massive supply glut that will take months (if not years) to ebb.

And for companies like Chevron and ConocoPhillips, which produce about 30% of their oil in the continental U.S., that outlook should worry investors. It's yet another reason to steer clear of the oil industry for now.